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May 4, 2012

Europe Tries to Regroup as Spain Falters

Largely ignoring sovereign debt woes in the region, European stocks inside the Vanguard MSCI Europe ETF were ahead by 7.65% this year

The ECB headquarters in Frankfurt, Germany. (Photo: AP)

Throughout Europe’s sovereign debt crisis, Greece has garnered most of the headlines. But now, the big two – Spain and Italy – are in the news and it’s not good.

The European Central Bank (ECB) has spent $1.31 trillion dollars trying to keep bond yields in the over-indebted countries like Spain and Italy from skyrocketing. But as of late, borrowing costs have been marching higher.

Spanish 10-year government yields have risen above 6% for the fourth time in the last year.

Short-term borrowing costs for Italy rose at government bond auctions in mid-April. Yields on 2.5 notes maturing in March 2015 jumped to 3.89% from 2.76% at the previous March 14 auction.

Spanish and Italian banks armed with money from the ECB have been snapping up the bulk of newly issued government debt along with other government bonds being sold by foreigners. This strategy has been referred to as the “Sarkozy carry trade” – named after France’s President Nicolas Sarkozy.

The central theory behind the “Sarkozy carry trade” is to lend local banks money that can in turn lend money to cash-strapped governments. All of this was meant to buy the government more time to clean up its financial act.

But since Spanish and Italian banks have burned through most of the money they borrowed from the ECB, it leaves their respective governments vulnerable to funding shortfalls. According to recent estimates, Spain has less than half of what it needs to borrow through the rest of 2012. Italian banks similarly are short on capital.

European stocks inside the Vanguard MSCI Europe ETF (VGK) are ahead by 7.65% this year and have largely ignored sovereign debt woes in the region. In a similar vein, the CurrenyShares Euro Trust (FXE), which is linked to the performance of the euro, has eked out a calm 1.99% gain.

In Europe’s banking sector, the iShares MSCI Europe Financials Index Fund (EUFN) has lost almost 30% in value over the past year. EUFN is still holding onto a 8.57% year-to-date gain, but a shortage of capital for banks is jeopardizing gains in bank shares. Bearish bets on the euro via the ProShares UltraShort Euro (EUO) and the ProShares UltraShort MSCI Europe ETF (EPV) have resulted in year-to-date losses of 5.11% and 19.14%, respectively. While bearish bets on the euro and European stocks hasn’t paid off just yet, patient bears are waiting this one out.

To stave off Europe’s ongoing crisis, it’s almost a given the ECB will be forced into another round of massive loans. Put another way: The more things change in Europe, the more they stay the same.